Model Portfolio rmcduff:RMG1

It's all relative . . .

The quarter ending September 30th, 2008 was certainly a tumultuous time. Irregardless of whether a "long only" manager maintained a value philosophy, a growth philosophy or growth at a reasonable price methodology, the outcome was the same; a down quarter.

It also made very little difference as to whether one was in large cap or small cap. The only differentiation between portfolios was based upon the percentage loss incurred in the quarter. Global investors, both personal and professional, went into net redemption mode.

RMG#1 has a global focus. The portfolio posted a loss of 14.3% for the quarter ending 09/30/08, and was down by 19.36% YTD.

I appraise the relative success, or lack thereof, against similarly configured publicly available mutual funds with a global theme, in similar cap weights. These peers include:

Trailing Returns as of 10/1/08

Returns assume reinvestment of dividends and distributions. Performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

1. All returns as of October 1, 2008
2. Mutual fund returns from Morningstar
3. RMG1 returns are from a model portfolio managed at www.marketocracy.com using virtual money. Returns include virtual transaction fees of 5 cents per share and virtual annual operating expenses of 1.95%

Among global portfolios with a larger cap focus, Morningstar reports that the representative fund in their coverage universe lost 27.72% YTD, as of September 30th, 2008. The Morgan Stanley Capital International Index, known as MSCI EAFE (developed) was down 29.26% YTD on that date.

The larger cap portfolio RMG#1 has maintained its #1 status among peers YTD. I am quite certain that none of the managers, me included, are impressed with the absolute negative returns posted year to date. Most of the managers in this class have exhibited minimal turnover of their holdings, since the end of the last quarter. This seems to imply that they are very much standing pat with their investment selections, as am I.

During periods of market volatility, investors can sometimes second guess themselves, and fall prey to panic, or media hype. The media has a 100% track record in reacting to events. However, the media's interpretation of such events, and predictive ability for the future, is not nearly so clear.

I believe that economic recessions have one great virtue. During periods such as now, truly world class companies become abundantly obvious to all. Poorly run firms, ordinary firms and many fine firms don't meet EBITDA and revenue expectations during downturns. Sometimes, earnings are met, but only with an * being attached to their financial statements, which is every bit as bad as a miss. However, there are companies in each and every economic cycle, which beat targets, and sometimes raise them.

At times such as now, I look to identify these corporations, potentially for inclusion in a portfolio. Businesses capable of beating expectations during tough times often become multi-baggers when economies revert to growth.

Here is a summary of the top three investment position in RMG#1 with my long term outlook. In addition, I am including a quick layout of what I feel are the key criticisms that generally represent the bearish thesis on each company.

Mastercard Inc (nyse: MA)

A. Mastercard (MA-NYSE $171.34). I consider Mastercard to be a global company, as more than 50% of its revenue is derived outside of North America. The company earns fees for processing transactions on its system, and has no direct exposure to bad debts or credit collections.

There are roughly 131 million shares outstanding, and the company had net liabilities on June 30th, 2008 of $3.04 billion. This produces an EV of $25.5 billion.

Mastercard, in my view, is a cash generating machine unlike few in the world today. The company has sustaining capital expenditures which appear to be less than $100 million per year. EBITDA for 2008 could exceed $1.7 billion, which prices the stock at 15X the current years EV/EBITDA ratio. Provided that the secular trend continues, MA could generate as much as $2.1 billion of EBITDA in 2009, for a ratio of 12X my 2008 estimate.

The shares were initially floated to the public at a ridiculously low valuation. MA rose quickly as investors became aware of the growth potential based upon the secular trend towards debit/credit usage vs. cash.

Mastercard shares have come down rather hard in the last quarter. The bearish case centers on the credit crisis, and valuation. In terms of the crisis, discussion centers on the possible slowdown in the growth of credit and debit card transactions by consumers. European, Asian and South American use expanded at anywhere from 15%-20% in the first half of 2008. In the US, volume growth was much lower. Should volume growth slow, EBITDA growth will also slow. This might result in further compression of the share price (valuation).

While I understand the bear case, even detractors can't see volumes NOT growing. Bears and bulls simply disagree as to the rate of future volume growth.

My ONE key concern is the possibility of some short term collateral damage, should Visa come up short on their forecast. Visa generates a far greater percentage of revenues from the US than does Mastercard. Visa also generates a very high percentage of volumes from California, which might be harder hit than other markets from the credit crisis.

Myself, I estimate that by 2018, at a 10%-12% rate of annual volume growth, MA could generate as much as $7 billion of EBITDA in that year. If the market continues to value the stock at 12X- 15X EBITDA, MasterCard could have an enterprise value of $84 billion-$105 billion at that time. I forecast up to $39 billion of EBITDA may be earned in that entire period, which greatly exceeds the market cap. In short, I believe that MA has the potential to be a multi-bagger for patient investors.

Novo-Nordisk A/S (nyse: NVO)

Novo-Nordisk (NVO-NYSE $52.91) is the world's leading pharmaceutical firm specializing in the treatment of diabetes. Headquartered in Denmark, NVO has a 53% (and growing) market share of the worldwide insulin market. In the US, Novo's market share is 42%. Diabetes care products accounted for roughly 73% of 2007 sales. The firm also has core strengths in hormone replacement therapy, haemostasis and growth hormones. Revenue could touch $9 billion in 2008 and $10 billion in 2009.

There are 623.5 million shares outstanding, for a market cap of $33 billion. NVO has net liabilities of just $1.25 billion, which produces an EV of $34.25 billion. I forecast that NVO may generate more than 2.8 billion of EBITDA in 2008. This may rise to $3.2 billion in 2009. This prices the shares at 10.7X my 2009 EV/EBITDA ratio, a four year low.

US sales of insulin products were up by an impressive 21% in the first half of 2008, a rising US dollar could materially bump revenues and earnings for the better. Novo generates roughly 53% of total revenues from North America. In local currencies, revenues were up by more than 13% in the first half of 2008. This reduced revenue growth somewhat for the first half of the year. However, for the quarter ending September 30th, 2008, the US dollar appreciated vs. the Danish krone. In early August, NVO raised earnings guidance by almost 10%, over their prior forecast. Since that time, the dollar has strengthened further.

EBITDA margins now exceed 30%, and have been rising year over year for quite some time. Novo has a potential diabetes blockbuster drug, Liraglutide, awaiting FDA approval, which may materially add to revenue and profit.

Bears, of which there appear to be few, tend to focus somewhat upon valuation. NVO has a flawless balance sheet, with little of the litigation that dogs most large pharmaceutical firms. Accordingly, the shares have tended to trade for a modest premium to peers in the marketplace. Detractors also appear concerned about difficulties experienced by a competitor, with an existing drug in the same class as Liraglutide.

I consider the modest premium valuation to be well deserved. Corporate governance is world class. NVO historically has quickly scrapped products that don't appear to be safe and effective, in the testing phase. This is why litigation is so light. I see few reasons to doubt management' current assertion; that Liraglutide is safer and more effective than the current standard. NVO seems to have gone above and beyond in its testing process. When/if the FDA clears Liraglutide for US sale, 2009 and 2010 earnings will need to be bumped up rapidly. If I am wrong, a company growing revenues by 10% + per annum, featuring 30%+ EBITDA margins still seems an impressive value at the current price.

Guangshen Railway (nyse: GSH)

Guangshen Railway (GSH-NYSE $26.03), is my top pick on the infrastructure and transport growth story in China. Guangshen operates high speed and normal freight rail lines in a heavily industrialized region of China. In mid 2007, GSH completed a major expansion of their high speed rail lines. In January 2007, management also purchased a sizeable trunk line from the Chinese government. The effective price was less than 8X EV/EBITDA. This purchase added a significant freight hauling business as well as long distance passenger revenue. Shares were sold to Chinese investors on the Shanghai stock exchange in December 2006, to raise the cash for the railway acquisition.

By my calculations, GSH had invested more than $450 million in the past 4 years to build its new high speed rail lines. This was paid for with internally generated cash flow. With the lines completed in 2007, management needed to purchase rolling stock to utilize the additional capacity. GSH added $375 million of debt in the last year, for the purchase of new train sets. Most of these were placed into service in early 2008.

There are 141.7 million shares outstanding, which creates a market cap of $3.7 billion. On June 30th, 2008, GSH had total net liabilities of $446.5 million. This produces an EV of $4.1465 billion. I estimate that GSH may generate $477-$500 million of EBITDA in 2008, and $515-$540 million of EBITDA in 2009. This effectively values the company at 8.7X the 2008 ratio, and less than 7.4X-7.8X my 2009 ratio.

The bearish sentiment on GSH comes from a sector dislike of China, coupled with the potential for additional competition from rails and bus in China.

I would note that as the Chinese stock market is off a whopping 65% from the 52 week high, there can't be many foreigners left in this sector. With GSH down by roughly 24% on the year, the shares have held up relatively well.

As to competition, with Chinese growth in both traffic and freight seeming to be a clear secular trend, there appears to be plenty of market share for all. In the next year, as the train set purchases are paid down, Guangshen should find itself with a very healthy cash flow to pay for more rail line assets, should they become available.

This is the only publicly traded railway in China with shares listed overseas. As I intend to benefit from the long term secular trend, Guangshen is the obvious choice.

At the current price, American investors are effectively paying less for GSH, than $27.45 US price paid per share by Chinese nationals in the secondary issue of almost 2 years ago. The shares now sell for a discount to North American peers, on a forward EV/EBITDA basis.

In closing, the media would have us in the throes of a pending great depression. This is exactly the same talk that I heard in the last several recessions. Recessions, while unwelcome, represent an inevitable part of the investment cycle. At their worst, recessions typically DELAY, but do not cancel, the progression of clearly defined secular trends.

In the weeks to come, I intend to provide my thesis on other holdings within the account, so as to bring investors up to speed with my approach and methodology. I look forward to sharing these views with you.

Regards,

Randolph